You may have heard about it on the news, your neighbors may be bragging about it or you could have even received eligibility notice in the mail — but what is the real deal behind refinancing? Before you crunch your personal numbers and weigh the costs and benefits of refinancing your mortgage, you need to be sure you understand what exactly we’re talking about.
How Does It Work?
Basically, refinancing a mortgage means getting a new loan with new terms on your home. When you went through the homebuying process, you likely thought — or hoped — that you were done with picking mortgages, but if you can secure a lower interest rate, need lower monthly payments or want to build equity in your home sooner through a shorter-term mortgage, it may be time to revisit your situation. Refinancing also gives you the option to switch between an adjustable-rate mortgage and a fixed-rate mortgage.
Should I Do It?
When making the decision, it’s important to consider your current mortgage size, details of the new mortgage you would be taking out, the current home value, the interest rate of your loan options and the closing costs. A refinance calculator can help determine if refinancing is right for you. You enter specific information about your personal finances and the calculator determines what makes the most sense for you. If you plan to stay in the house longer than it will take for the monthly savings on your new mortgage to recoup the upfront costs of refinancing, you may want to move forward.
What Will It Cost?
When you bought your home, you probably paid closing costs to complete the sale. When you refinance, you have to pay these again to replace your original mortgage with the new one. You can expect to fork over 3% to 6% of your principal in refinancing fees along with any prepayment penalties you could incur. Beware that if you are offered a “no-fee” refinance, the lender may be charging you extra interest to make up for the fees you are avoiding upfront.
When Is It a Bad Idea?
Refinancing may sound great, but it isn’t for everyone. You need to be eligible for the new loan, which means you usually need to have a certain amount of equity in your home and decent credit score. (If you’re not sure where you stand, you can check a free credit report summary at Credit.com.) If you don’t qualify, it obviously isn’t an option for you. You also should probably not refinance if you plan to move from your home soon, since this doesn’t give you time to recoup the closing costs for the new loan. Being able to afford closing costs upfront is also important. Though lenders may offer the option to roll them into your new mortgage, this isn’t always the best decision and can cancel out the savings you would make from the switch. Also, if the prepayment penalty on your original mortgage is too high, this can also negate the potential savings of a refinance.
This article originally appeared on Credit.com.